Daniel Gorfine
Adjunct Fellow; Vice President, External Affairs and Associate General Counsel, OnDeck
Capital Access and Capital Markets and Demographics and FinTech and Global Economy and Public Policy
Daniel Gorfine is an adjunct fellow at the Milken Institute and vice president, external affairs and associate general counsel at OnDeck, a technology-based company focused on transforming small business lending.
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MI-GU Hill Briefing: "The role of private equity in capital formation"
By: Daniel Gorfine
March 27, 2012
The Milken Institute's Center for Financial Markets and Georgetown University's Center for Financial Markets and Policy at the McDonough School of Business recently held the latest in their joint Capitol Hill briefing series, this time focused on the role of private equity (PE) in capital formation. The panelists included Sandeep Dahiya, associate professor at the McDonough School of Business; David Marchick, Managing Director at the Carlyle Group; and Joel Kurtzman, Senior Fellow at the Milken Institute and board member of the Private Equity Research Institute. Bradley Belt, Senior Managing Director at the Milken Institute, moderated the panel, and Reena Aggarwal, professor of business administration and director of McDonough's Center for Financial Markets and Policy, introduced the panel.

The speakers discussed the various roles of private equity in a modern economy, the impact of private equity on job creation, and the hot-button issues relating to private equity that have recently attracted significant public attention, including its tax treatment and potential contribution to systemic risk.

Some noteworthy takeaways:
• The panelists explained that PE firms today do far more than engaging in highly leveraged buyouts and taking public companies private. There are a variety of operating structures and investment approaches, including into infrastructure, real estate, and equity funds. Private equity typically attracts long-term investors with five- to ten-year investment horizons. Usually, PE investors include private and public pension funds as well as university endowments. One panelist noted that the majority of PE firms are small in size and invest in family-owned businesses seeking capital or operational expertise.

• The question was raised whether PE should be viewed as an asset-class or an industry, based on its various investment and operational approaches. One panelist noted that PE is defined differently by the multiple stakeholders with which it engages: institutional investors view PE as an asset-class capable of providing investment diversification, while commercial entities may view PE as an industry that can provide needed capital or operational expertise. Another panelist observed that PE can also be defined as a model of governance, which efficiently aligns the interests of investors, board members, and management.

• While institutional investors appear to have an increasing appetite for PE, particularly given low returns on fixed income investments, the available evidence indicates only the top quartile of PE firms are able to generate consistent "PE-like" returns. It was also noted that because many PE firms in the United States are relatively small and comprise friend and family investors, it can be difficult to generate robust data on PE performance. The Private Capital Research Institute is developing a comprehensive database on PE performance metrics to better quantify PE results and related market impact.

• The panelists were largely in agreement that PE ultimately has a "net zero" effect on job creation. In contrast to PE transactions of prior decades, when buyout firms targeted bloated and inefficient conglomerates in order to slash costs, most of today's PE firms are instead focused on extracting value through improving operations and corporate governance. One panelist noted that job effects are better understood as symptoms of efficiency gains brought about by operational improvements, while another observed that PE firms typically engage in Schumpeterian creative destruction, whereby workers at inefficient companies are initially shed, but ultimately new workers are hired when the leaner entity seeks to expand its profitable operations.

• On the topic of carried interest and taxation of PE profits, one panelist noted that differential treatment for carried interest was similar to that for real estate transactions (e.g., the return on "sweat equity" in improving a home is accorded capital gains treatment when a house is sold), while another observed that, in contrast, contingent, success, or transaction-based compensation earned by other professionals, such as athletes and investment bankers, is treated as ordinary income. The point was also made that another risk PE firms face is that poor investment returns will trigger clawback provisions that require the PE firm to return certain funds to investors at the direct expense of the PE firm.

• As for the potential of PE firms to contribute to systemic market risk, it was noted that despite the high-profile of private equity, even the largest PE firms are much smaller than many other traditional financial institutions, and thus are unlikely to pose systemic risks.